What is a Government Bond & how does it work?

If you're looking to diversify your investment portfolio with a low-risk and stable option, government bonds—also known as gilts—can be a good choice. In this blog, we’ll explore what government bonds are, the different types available, their benefits, and the risks involved in investing in them.

What is a government bond?

What are govt bonds? They are debt securities issued by national governments to raise capital for financing various public expenditures and projects. These financial instruments represent loans made by investors to the government, with the promise of repayment with interest at a predetermined future date. Government bonds' meaning encompasses one of the safest investment options available in the market, backed by the full faith and credit of the issuing government. In India, these bonds play a crucial role in the financial ecosystem, offering investors a reliable avenue for capital preservation while earning steady returns.

Government bonds meaning

A government bond definition is a fixed-income security where you as investors lend money to the government for a specified period in exchange for regular interest payments and the return of the principal amount at maturity. These bonds are essentially issued by the government, promising to repay the borrowed amount with interest. Unlike corporate bonds, government bonds distinguish themselves through their backing by sovereign authority, making them virtually risk-free in terms of default. The Indian government issues various types of bonds through the Reserve Bank of India, with maturities ranging from short-term treasury bills to long-term dated securities spanning decades. What are government bonds if not the cornerstone of financial stability for conservative investors seeking predictable returns?

How do government bonds work?

When you purchase a government bond, you're effectively lending money to the government for a predetermined period. The government, in turn, agrees to pay you interest, known as the coupon rate, typically every six months until the bond matures. At maturity, you receive the face value of the bond regardless of what you initially paid for it.

For instance, if you invest in a ₹10,000 bond with a 5% annual coupon rate and a 10-year maturity, you'll receive ₹500 (5% of ₹10,000) annually, usually split into two semi-annual payments of ₹250 each. After 10 years, you'll get back your original ₹10,000 investment.

The price of existing bonds fluctuates in the secondary market based on prevailing interest rates. If rates rise, bond prices typically fall, and vice versa. This inverse relationship is fundamental to understanding government bonds in a dynamic economic environment.

Types of government bonds

• Treasury bills (T-Bills): These are short-term securities that mature in less than one year, typically with terms of 91, 182, or 364 days. T-bills are issued at a discount to their face value and don't pay regular interest. Instead, the difference between the purchase price and face value represents the interest earned.
• Dated government securities: These medium to long-term bonds have maturities ranging from 5 to 40 years. They pay fixed or floating interest rates semi-annually and return the principal at maturity. These form the backbone of the Indian government debt market.
• Inflation-indexed bonds: These bonds protect investors against inflation by linking the principal amount to an inflation index. Both the principal and interest payments adjust with inflation, preserving purchasing power.
• Sovereign Gold Bonds (SGBs): These special bonds are linked to the price of gold. Investors earn interest while also benefiting from potential gold price appreciation, all without the hassles of physical gold storage.
• Floating-rate bonds: Unlike fixed-rate bonds, these securities offer interest rates that fluctuate based on benchmark rates, protecting against interest rate rises.
• State development loans: These are bonds issued by Indian state governments to fund their development activities, typically offering slightly higher yields than central government securities.

Advantages of government bonds

• Safety: They carry minimal default risk as they're backed by the government's ability to tax and print currency, making them among the safest investment options available.
• Predictable income stream: The fixed interest payments provide a steady, reliable income, particularly valuable for retirees and conservative investors seeking stability.
• Liquidity: Government bonds can be easily bought and sold in the secondary market, providing investors with access to cash when needed.
• Portfolio diversification: Adding government bonds to your investment portfolio helps balance riskier assets, such as stocks, thereby reducing overall portfolio volatility.
• Inflation protection: Certain government bonds, such as inflation-indexed bonds, offer protection against rising prices by adjusting returns in response to inflation rates.
• Tax benefits: Certain government bonds offer tax advantages, making them an attractive option for tax-efficient investment planning.

Who should buy government bonds?

• Risk-averse investors: If you prioritise capital preservation over high returns, government bonds provide the safety net you seek, with virtually no risk of losing your principal.
• Retirees and pension funds: Those needing regular, dependable income streams benefit from the predictable interest payments that government bonds provide.
• Portfolio balancers: Investors seeking to offset riskier investments, such as stocks, can utilise government bonds to stabilise their overall portfolio returns during market volatility.
• Short-term goal planners: If you have financial goals within 3-5 years, government bonds offer better returns than savings accounts while maintaining capital safety.
• Corporate treasuries: Companies with excess cash reserves often invest their funds in government securities for safety, earning returns that exceed those of bank deposits.
• First-time bond investors: Those new to fixed-income investing can begin with government bonds to understand bond mechanics before transitioning to riskier corporate bonds.

What affects the price of government bonds?

• Interest rate changes: When central banks raise interest rates, prices of existing bonds typically fall as newer bonds offer higher yields. Conversely, when rates fall, existing bond prices rise.
• Inflation expectations: Higher anticipated inflation erodes the purchasing power of future bond payments, causing bond prices to decline and yields to rise as investors demand compensation for inflation.
• Market demand: Strong demand from institutional investors or foreign entities can drive up bond prices and push yields lower, regardless of other economic factors.
• Economic outlook: Expectations about economic growth influence bond prices, with stronger growth forecasts often leading to higher yields and lower prices.

Risks of government bonds

• Interest rate risk: When interest rates rise, bond prices fall. If you sell before maturity during a rising rate environment, you might incur capital losses.
• Inflation risk: Fixed-rate bonds can lose purchasing power during periods of high inflation, as the actual value of both interest payments and principal declines.
• Liquidity risk: While generally liquid, certain specialised government bonds may have limited secondary market activity, making them difficult to sell quickly without price concessions.
• Reinvestment risk: When bonds mature or make interest payments during low-rate environments, reinvesting those proceeds at comparable rates becomes challenging.
• Policy risk: Changes in government fiscal policies or debt management strategies can unexpectedly impact bond valuations.

Also Read: Understanding different types of Bonds

Disclaimer: This article is for information purpose only. The views expressed in this article are personal and do not necessarily constitute the views of Axis Bank Ltd. and its employees. Axis Bank Ltd. and/or the author shall not be responsible for any direct / indirect loss or liability incurred by the reader for taking any financial decisions based on the contents and information. Please consult your financial advisor before making any financial decision.